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Brazil : the show must go on ! But will it ?

The beginning of June saw a flurry of announcements both from the BCB and also the Government of Dilma Rousseff. The objective is clearly to reassure the market about the capacity of the Brazilian authorities to manage the current situation.

The monetary tightening cycle, unlike that suggested by previous releases of the BCB, should continue.

The BCB admits that efforts so far have not been as successful as expected and suggests that there are risks that inflation, heretofore considered inherent to short-term factors, could become structural.

The plan « stimulus » announced by Dilma Rousseff will have little short-term effect even if the funding would be combined

Introduction

The first two weeks of June saw a flurry of announcements from Brazil and echoed our article entitled « Brazil at a Crossroads ». We feel that two of these announcements merit our analysis. The first relates to a decision by the Banco Central do Brasil (BCB) to hike interest rates once again, but what we found interesting was not this decision itself, which was anticipated by markets, but rather the minutes published a week later. The second announcement that stood out was Dilma Rousseff’s new infrastructure development plan. The two announcements raise the following questions :

Will a conventional monetary policy be enough to reassure the markets ?

Will Rousseff’s announcements on the outlook for a new stimulus plan prove to be an illusion ?

The Banco Central do Brasil has adopted an « alarmist », if not « alarming », position…

Given May’s poor inflation figures, to bolster its credibility, the BCB had no alternative but to hike its interest rates once again, and this is certainly what was being priced in by the markets. However, while it has suggested until now that the end of the tightening cycle is near, the most recent monetary policy committee (Copom) minutes appeared to indicate that things could play out differently. Indeed, the previous Copom statements had been more reassuring as to the reversal of the inflation trend. The latest Copom minutes released on June 3 support the assessment that we had established on the BCB’s potential loss of control over inflation in our focus. Indeed, we showed that the cyclical effects (depreciation of the real, liberalisation of administered prices) were not the only factors contributing to the rise of inflation and that, as a result, the BCB’s reliance on the reduction of these cyclical effects to bring inflation back to its target1 was a risky bet.

Today, the BCB appears to have adopted a more « alarmist » if not « alarming » approach. Firstly, the fact that it indicated in its statement that the June 3 decision to increase the Selic by 50 bp to 13.75% was unanimous is not neutral. Doubtless, the latest inflation figures for May contributed to this decision. Indeed, despite previous rate increases, consumer prices continued to rise last month (8.47% year-on-year compared to 8.17% the previous month). The BCB therefore mentioned that despite measures taken to combat inflation, and domestic factors that should have headed in that direction (decline in private consumption and slowdown of the labour market), progress was still insufficient. In addition to mentioning the fact that inflation will likely remain high in 2015, the BCB explicitly adds that it must show « determination and perseverance to prevent the transmission of current inflation to longer tenors », thereby suggesting that a risk of deterioration cannot be eliminated, all the more so given that despite the cyclical slowdown, wages continue to increase.

…but all the same, it is trying to reassure the markets as to the consistency and continuation of the policy mix

Faced with the current situation, the BCB was forced to admit that it has yet to win the fight against inflation. Such an admission, although accompanied by an appropriate decision, weakens the BCB in the sense that the credibility of its policy is increasingly constrained by markets, which are expecting further rate increases. As a result, the BCB is attempting to remain positive by affirming in its statement that it will be vigilant and that it will not stray from its goal of bringing inflation to its target in 2016.The other very interesting point in this statement is, of course, the reference to budgetary policy. As we underscored in our focus article, continued monetary tightening, coupled with a restrictive budgetary policy, may be undermined against a backdrop of recession. We therefore note the risk of a return to fiscal dominance. In reaffirming that the budgetary policy’s impact on monetary policy will remain neutral, the BCB appears to have attempted to address these assertions.From our perspective, as long as wages continue to increase and households’purchasing power does not fall too steeply due to inflation, and if the labour market does not deteriorate significantly, it is possible that this policy mix will continue. However, it is clear that with drastically reduced investment and the developing recession, the labour market is beginning to decline. Pressures on wages will therefore decrease — a positive for inflation and terms of trade, but negative for domestic consumption and the risk of social stresses.

For her part, Rousseff announced a stimulus plan in support of the BCB

While economic indicators in general — and low investment in particular, which is a key weakness of the Brazilian economy — headed into the red, Dilma Rousseff announced a stimulus plan worth over USD 65 billion, which aims to enhance Brazilian infrastructure (rail, road, air and shipping networks). According to the Brazilian government, 65% of this amount will be invested by the end of 2019. This stimulus plan comes at just the right time and will help to counter the negative growth effects of budget consolidation necessary for public finances to recover and to limit the risk of social unrest.

To finance these « major projects », the government intends to use the Brazilian Development Bank’s (BNDES) resources, which we note have been significantly reduced, in addition to calling on private investors. At the moment, we have little information on the concessions that the Brazilian government is prepared to make to private investors apart from granting greater autonomy in decisionmaking.

From our perspective, the stimulus plan is more or less for show. There is no guarantee that investors will respond as positively as hoped for. Note that in 2012, Brazil had already launched this kind of project and raised only 20% of the funds that it expected. Finally, even when the funds are amassed, in the short term (the next six months) little impact is expected apart from limiting the current deterioration of the labour market, thereby limiting the undermining of an overly strict policy mix.